Meeting New Zealand's energy needs isn't as simple as most people seem to think. Consuming energy means making trade offs. Even conserving energy means making trade offs. Some are economic but some come down to physics.

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Sunday, November 1, 2009

Is there a free rider problem in New Zealand's retail electricity market?

I think there are problems in New Zealand's retail electricity market but the focus is always on the wholesale market. (see http://www.energycomment.co.nz/2009/10/what-is-problem-with-retail-competition.html) Obviously many people are upset at the significant increases in retail prices over recent years. The Electricity Commission's own analysis shows the issue quite well (see Chapter 2 of http://www.electricitycommission.govt.nz/pdfs/opdev/wholesale/market-design/Market-Design-Review.pdf) Although, unfortunately, the analysis doesn't go as far as to compare industrial, commercial and retail margins, only prices, therefore there is a degree of comparing apples and oranges. This is compounded because prices include both energy costs and lines costs. Nevertheless, it is clear that industrial prices have been quite flat (in real terms), commercial prices have dropped markedly and retail prices have gone up markedly. Interestingly the national average end use purchaser price has also remained relatively flat.

For most of New Zealand's history there have been significant cross-subsidies in the retail prices. Traditionally residential prices were arbitrarily low and commercial prices were arbitrarily high. Industrial prices have always been, effectively, wholesale prices. The reason for the historical cross subsidy from commercial to residential is easily explained. This occurred because electricity was delivered by monopolies with elected governors, and businesses don't vote. A simple case of responding to the incentives of the day.

It is clear that these historical cross subsidies have been removed and this is one reason why residential electricity prices have increased in excess of inflation. Now, though, the situation seems to have reversed with residential prices being significantly higher than commercial, but this may not be a cross subsidy. It may just be economic reality.

And what of industrial prices. To a degree the industrial price is lower because it is generally a wholesale price. But is there a degree of cross subsidisation here? There isn't really enough analysis to be able to conclude much at all. Let's instead consider a 'first principles' debate around allocative efficiency.

Allocative efficiency is that economic principle that says that resources should be allocated to their most valuable use. This roughly translates to - those that are willing to pay more should get all they want and people who are willing to pay the least should get less. It can also be translated into saying that those that get the most should pay the most and the those that get the least should pay the least. If we hold off for a moment on the distinction between commercial and residential (and treat them as one retail customer bloc) then let's compare them (together) to the industrial segment.

It looks to me that allocative efficiency is working properly here. Notwithstanding that industrial prices are generally wholesale prices they seem to pay the least. Industry is also the segment most likely to shut down when there is an energy shortage. As wholesale prices increase more then more industrials shut down. Prima facie this is what you would expect. Having said that the industrials (in general) have the same mantra during any energy shortage - why do we have to bear the brunt of energy shortages? Why don't retail customers bear the burden as well? Well, the easy economic answer is because industrial loads are willing to pay less than retail customers and, therefore, industrial loads should be the first off. In complaining that they shouldn't be shutting down, and that this is doing New Zealand economic damage, then there are two implicit sides to this potential debate:

Allocative efficiency is working well and industrials are just engaging in political manouvering (a strong possibility), or

Allocative efficiency is not working and industrial loads should not be first off (but, of course, this also means that they should pay more, ie there is currently a cross subsidy from industrial customers to retail customers)

The situation seems more clear when it comes to commercial and residential comparisons. Neither responds strongly to price signals and yet each pays significantly different prices. A cross subsidy seems most likely here.

So why might cross subsidies exist? Prevailing opinion would probably suggest that it is the evil retailers that are price gouging, but this does not make sense. As mentioned the national average end user purchase price is relatively constant over time in real terms. There is no obvious price gouging in end user prices. Maybe one could argue that retailers (or lines companies) are forcing cross subsidies - but why would they? There is no obvious financial benefit to a power company in forcing an unbalanced price structure. It is more likely that power companies (as with previous cross subsidies) are just responding to the incentives that they have.

There are two reasons I can currently think of why these incentives might exist. Both are a form of free rider problem. One potentially explains why there might exist a cross subsidy from retail customers to industry.

E Grant Read in his 2009 paper (http://www.mightyriverpower.co.nz/content/1798/Electricity%20Market%20Economics-%2090302.pdf) explains the relationship between contract prices and wholesale prices in electricity markets. Over time electricity generators must recover their fixed costs (costs that are incurred irrespective of how much they generate - plant costs, most labour, infrastructure, capital, etc) and variable costs (costs that are incurred when they generate - fuel, some maintenance, opportunity costs, etc), otherwise they would not invest. In the absence of any contracts then usually (during normal times and especially during times of surplus) the generators will only get variable costs paid out of the market. Only during times of shortage will generators be able to get a contribution to fixed costs. An unhedged electricity market should be highly volatile and have a high total price (high enough to cover all fixed and variable costs). If generators are highly hedged at the total price of generation then the electricity market should be far less volatile and have a lower price (equal to the average of variable costs only as settlements to hedge contracts will pay the fixed costs).

This is where a cross subsidy may, unwittingly, occur. If a retail market design problem meant that retail consumers are making a large contribution to fixed costs then those retail contracts would help stabilise the wholesale price and tend to clear a lower wholesale price. This would enable industrial customers to free ride in the sense that they could take the lower volatility and lower price in the wholesale market and, potentially, avoid some contribution to the fixed costs of generation. Although they would continue to be able to complain about the wholesale price and volatility.

If we look at the relationship between residential and commercial customers then another free riding problem may exist. I suspect that the commercial electricity price is dominated (by volume) by national scale business. These businesses tend to tender for their (relatively large) electricity supply whereas retail customers tend to either be approached or infrequently consider their suppliers (for relatively small load on an individual basis). This means that the larger businesses tend to offer retailers a single shot bid on a lucrative volume (large commercial businesses also tend to be low engagement and good payers). This design is likely to inherently mean that commercial (and possibly industrial) customers are likely to get offered average prices while residential customers will tend to get marginal prices (the full cost of continuing to supply energy at that time at that level). In fact residential customers may pay in excess of the marginal cost, to the extent that commercial (and industrial) customers might avoid fixed costs. Pure allocative efficiency suggests that everyone should face the marginal price.

Some people have argued that the problems with the retail electricity market are structural (relating to the number and type of competitors) and, often, that it is a problem with the wholesale market. I don't think that either proposition is correct. I think that the problem is fundamentally one of retail electricity market design; and let's face it the retail electricity market was never designed - it coalesced over time. Fixing the retail market design may have implications for both the electricity market structure and the wholesale electricity market but these outcomes shouldn't be the objective of fixing the retail market.

Obviously the arguments above are purely anecdotal . The analysis required to properly assess the efficacy and efficiency of the retail electricity market is complex and requires information not readily available; and, perhaps, this is part of the problem. Nevertheless, I don't believe that the electricity market in New Zealand (or any alternative) is ever going to work properly unless every part of it is considered as a policy whole. At the moment the retail component is a significant missing link in the policy debate in anything other than an anecdotal discussion.

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I've never been a particularly open person, perhaps even a bit reserved. I have only a few friends (but good friends they are). I think a lot and I read a lot. I have a reputation for knowing too much, but I don't think I know enough (except electricity - I know way too much about electricity). I probably don't have enough fun but I'm getting better.